Life Insurance 101

Generally speaking there are two types of insurance: term insurance and permanent insurance.

Term insurance provides a death benefit for a period of time in exchange for a premium payment. The minimum term available is usually one year. Generally, term insurance is inexpensive at younger ages and becomes more expensive as the insured gets older.

Annual renewable term was historically used to cover a risk that is limited in duration, and where low cost in the early years is a driving factor in the choice of insurance. Candidates for this type of coverage could include: young people just starting out; entrepreneurs obligated to provide coverage as additional security on a short term bank loan; or business owners with limited current cash flow.

The disadvantage to using term insurance is that sooner or later the term ends. If insurance is desired after the term, new insurance must be applied for. If health has become an issue in the intervening years, replacement insurance may be either very expensive or in some situations, not available at all. For this reason, many companies created a term insurance product that provided a contractual right to convert to a permanent insurance product, sometimes without any additional medical underwriting or exams.

The second major category of insurance is often called "permanent insurance," although not all permanent insurance is permanent in the way most people think of that word.

Historically, permanent insurance meant whole life insurance. This type of insurance really was designed to be permanent. The insurance company calculated the amount of premium you would need to keep the policy in force until age 100.

Basically, the insurance company combined a term insurance product with a savings account. Each year as you built up more and more money in the savings account, the amount of term insurance in the contract decreased until age 100, when the amount in the savings account was designed to be equal to the death benefit. Premiums for whole life insurance tend to be the highest of all types of permanent insurance.

This type of policy is often used in business situations to address a buyout of a co-owner in the event of disability or retirement, because the cash value in the policy over time functions as a sinking fund. The longer the business operates, the greater the value and buyout obligation. This increase can be matched by the increasing cash value in the policy. Of course the death benefit function can also be used in a buyout situation where one of the partners dies.

The disadvantage to whole life is usually the cost relative to the death benefit. For this reason, a combination of term and whole life is often recommended so that both the need to provide protection for a period of time (term insurance) and the need to have cash savings (whole life) can be met. Because this is a compromise, neither goal can be fully met, but often you will achieve a satisfactory result.

For those with a need for insurance, coupled with a desire for higher investment returns than usually seen in life insurance policies, there exists the variable universal life policy. This type of policy functions like a universal life contract and has lots of flexibility.

One key difference is that the owner of a variable life insurance policy can invest cash value in a vast array of sub-account portfolios, thereby having the possibility of benefiting from increases in the stock market. If the market does well, these gains can outpace the returns normally seen in a life insurance policy, resulting in higher cash value or lower premiums or both.

Your advisory team, especially your life insurance agent or financial planner will be able to answer any questions you may have.